An Unholy Brew

Be prepared — rises in the price of food and oil are here to stay. 


Listener: 26 July, 2008. 


Keywords: Globalisation & Trade; 


Long-time readers will not be surprised at the higher prices for food and oil. We can expect them to rise (relatively) as the terms of trade switch in favour of food and against manufactures and as the supply of oil fails to keep up with growing demand. 


Previous columns have also mentioned the possibility of price spikes, the- sharp temporary rises in commodity prices above the long-term rising trend. Although the height of these spikes is not surprising in hindsight (and with some knowledge of elementary economics), some explanation might be useful. 


A rise in prices indicates that demand is rising faster than supply (at current prices). In the case of oil, the world requires more energy, as economic production has been expanding rapidly, especially in some energy-inefficient economies such as China. A rise in the price does two things: it reduces demand and increases supply. If it does not do that enough, then the price will rise again. 


However, an oil price rise does not reduce demand much. It is difficult to change quickly to a more fuel-efficient car, or switch to public transport (which may not yet be available), or move your house closer to your job or vice versa, or insulate it better. Firms can’t quickly introduce energy-saving production technologies. You, and the rest of the world, have made some adjustments, but not enough to dampen the spike. 


Meanwhile, the supply side cannot respond much in the short term, either. The world is very close to producing all the oil it can, which is not currently a matter of what is underground, but the production facilities pumping it out. In principle, we can switch to other transport energy sources, but the stock of biofuel and electricity-driven vehicles cannot be markedly increased overnight. 


So prices will rise until they hurt enough to choke off demand. That can be a big hurt to some. Since food production is not keeping up with demand (and supply is being affected by droughts and suchlike), there is a food shortage. 


The rich world feels the pain of paying more for its food, but I doubt it will cut back much on consumption. 


Someone has to; I fear it’s those in Third World countries already in poverty and suffering malnutrition, often spending 80% and more of their budget on food. I’m afraid there will be more starvation. 


We should not blame that on the high prices. There would still be the shortages without them. Sure, people are benefiting from the higher prices, including New Zealand farmers and energy producers. You may think this is unjust, but interfering with these price signals could make matters worse, reducing the supply and aggravating the shortages. 

I have no great fondness for speculators, but the high prices would have happened anyway. I am even more disturbed by some rich countries adopting beggar-my-neighbour food policies, pushing the shortage on to others elsewhere – typically the malnourished. 


If people were not suffering so much, an economist could take pleasure in seeing simple economic principles so well illustrated and, especially, economic responses reflecting physical realities in the real world. 


I admit, though, that previous columns have not given enough attention to the interaction between the food, economic, energy and biofuels sectors. To this unholy brew we must add global warming. 


The world economy is “twisting”, with some sectors expanding and others contracting. This happened to New Zealand in the 1970s in response to the fall in the price of our then principal export, wool. It caused much economic pain. This time it is the whole world (and New Zealand may be a beneficiary of this twist). 


<>Implicit in this analysis is that over time commodities will come off the price spike as supply and demand adapt better (and there is also the possibility of a world recession). But almost certainly oil (and food) prices are going to be higher. Because it is so hard to adjust, start preparing for that now. You have been warned (again).